Back in 2011, wealthy Chinese investors fell in love with a structured product called Credit Equals Gold No. 1. It raised $500 million to back a coal-mining venture in the north of the country, by offering a return of 10%. It was sold through the offices of a reputable bank. It was issued by China Credit, 33% owned by the state.

Istanbul

Three years on, the company cannot repay its debt. According to the Wall Street Journal, its owner has been detained by the authorities in connection with his financial affairs and could not be reached for comment. Investors are being bailed out, says China Credit.

A year ago, the incident would scarcely have registered. The situation appears to have been resolved quickly.

But this has not prevented comments by market participants that Credit Equals Gold No. 1 heralds problems for China’s shadow banking system, as debt levels spiral. Interbank rates have risen, amid fears of a liquidity squeeze. Falls in GDP growth from 9% to 7.7% have cut the country’s room for manoeuvre: some say the real increase is closer to 5%.

The panic has not been confined to China. Last year saw net outflows of $33 billion from emerging market bond and equity funds. Outflows accelerated in January. Central banks in India, South Africa and Turkey have each hiked interest rates to protect their currencies. The Argentine peso has crashed 15%. Rioters have taken to the streets in Brazil.

The great dreams of emerging markets investors have turned to nightmares.

Strangely, or perhaps not, Europe’s debt overhang has been forgotten amid a plethora of “buy” recommendations. Fears for its periphery states are yesterday’s story. Ireland has escaped the European Union rescue programme and Portugal is talking about doing the same. Spanish sovereign bond primary issuance is being covered several times over.

JP Morgan Asset Management was brave enough to call the turn for Europe last June. It has just told its clients to keep buying. UK retail funds celebrated the economic revival with a 42% rise in inflows to £20.4 billion last year, according to the Investment Management Association.

Crisis? What crisis? To judge by the growing optimism, I wouldn’t be surprised to see Greece finance itself out of the EU rescue programme by the end of the year.

Pendulum swings

How can sentiment swing so suddenly – and so decisively?

François Sicart of French asset manager Tocqueville believes investors have ceased to live in the real world.

By interpreting, and reinterpreting, different events individuals find reasons to buy or sell securities and products. Sometimes the analysis is perceptive. It can be supported by grass roots research. But people also trade on momentum or newsflow to turn a profit, or sell a product.

The mood of the markets is hard to capture. The Santa Fe Institute calls them “complex adaptive systems” that “create novelty, self-organise, evolve and adapt to a changing environment, usually generating more complexity in the process”.

Views are all too frequently simplistic, subjective, misleading or all three. They interact to create a “trend” that can easily be exaggerated or distorted, which is why traders say Credit Equals Gold No.1 heralds problems for the Chinese shadow banking system.

Hedge fund manager George Soros calls this approach reflexivity, where action and behaviour interact. He once said: “That makes reflexivity a very broad phenomenon that typically takes the form of feedback loops. The participants’ views influence the course of events and the course of events influences the participants’ views.”

He views the divergence between perceptions and reality built up through subjective opinion as crucial to developing a bubble. Perception is often confused with reality, particularly by individuals when they are too rushed to research things properly. This can lead to a bubble. But more often, a speculative frenzy gets defused when investors sense reality, before euphoria builds up.

Reality check

The reality check for emerging markets took place when Federal Reserve chairman Ben Bernanke first suggested tapering US quantitative easing last May.

Until then, investors had gone along with the optimistic view that emerging markets would continue growing, after attracting capital worth an estimated $7 trillion since 2005.

After Bernanke’s remarks, investors started to reflect on the size of loans being run up by the private and public sector. The strength of the dollar and rising interest rates made them intensely nervous.

Guy Wolf, an analyst at broker Marex Spectron, said: “It is almost a definition of an emerging market that it has to borrow in dollars rather than its own currency. So the bulk of capital is a leveraged carry trade and, therefore, prone to sharp withdrawals. Now that the distortions from central banks are at record levels, it stands to reason that the sensitivities are as well.”

Outflows from exchange-traded funds punished emerging market indices by 10% a month after Bernanke’s comments. Hedge funds that latched on to the theme faster than most investors were quick to cut their positions. Last month, emerging market stocks were being hit again, as currencies were hit. Some falls have been brutal.

Marex Spectron’s Wolf said: “There is always a trigger point at which foreign exchange losses outweigh the positive carry. So unwinds tend to be brutal when they happen.”

Don’t be fooled

But Percival Stanion, head of multi-asset strategy at Baring Asset Management, points out each country is travelling in a different direction. He said: “They are all dysfunctional in their own way.”

And as Neil MacKinnon, a macro strategist at VTB Capital, points out on page 6, the noise generated by emerging market economies is greater than their size.

The gloom in a few emerging market countries is masking optimism elsewhere. Russia is facing a nervous upswing and Mexico is enjoying a strong one. Young populations and natural resources are improving the outlook for African economies. Even Egypt may be facing a more secure future under its new military dictatorship. Asian manufacturers are starting to prosper as US consumers take advantage of dollar strength to start buying again.

Even after recent cuts, forecasts of GDP growth in emerging markets are twice the rest of the world.

Most countries are easily capable of servicing their debt burden, which is more than you can say about Europe. It helps that foreign reserves built up by emerging market economies are close to record levels.

It is also worth pointing out that the MSCI emerging markets index has only fallen by 12% over the past year. This implies a net loss of 31%, taking account of a 19% gain for the S&P 500 index, but it does not amount to a rout. It confirms the view that earnings multiples were not in bubble territory before last year’s reaction to Bernanke.

Those investors trying to sense the mood of the market with the help of past experience say we could be heading for a rerun of the 1997 Asian debt crisis. They argue emerging market countries are skating on thin ice. They say they are dancing on the edge of a volcano.

Don’t be fooled. Nations capable of such feats are capable of anything.

--This article first appeared in the print edition of Financial News dated February 3, 2014